Denmark Has Lessons for Draghi as Official Rates Go Negative

After breaching the zero threshold last month, Nationalbanken’s arsenal of tools to stem krone appreciation is slowly being spent. Photographer: Linus Hook/Bloomberg

Aug. 1 (Bloomberg) -- As Denmark experiments with official
interest rates below zero, European Central Bank President Mario
Draghi is getting a glimpse of how extreme monetary policy
decisions play out in real life.

Nationalbanken in Copenhagen, which lowered the rate it
offers on certificates of deposit by a quarter of a percentage
point to minus 0.2 percent on July 5, has become “a test
case,” Paul Mortimer-Lee, global head of market economics at
BNP Paribas SA in London, said in an interview. “We should take
note when our knowledge of this stuff is scarce.”

Danish central bank Governor Nils Bernstein has gone one
step further than Draghi in doing whatever it takes to meet his
monetary policy goal. For Bernstein, it’s about deflecting a
capital influx that threatens to strengthen the krone beyond the
limits of its euro peg. For Draghi, negative rates would spur
banks to lend. The ECB, which lowered its deposit rate to zero
last month, will probably leave rates unchanged at its meeting
tomorrow, according to a Bloomberg survey.

“We’re living in extremely volatile times,” Jesper Berg,
senior vice president at Nykredit A/S and a former Danish
central bank department head who also worked at the ECB, said in
an interview in Copenhagen. “Scenarios that were unthinkable
just years and months ago are playing out in front of us.”

Denmark is now finding out just what it means to have
negative rates. After breaching the zero threshold last month,
the bank’s arsenal of tools to stem krone appreciation is slowly
being spent.

‘No Limit’

“The Danish central bank has at most one more rate cut at
its disposal, and then that tool is used up,” Berg said. “From
there on, it’s the foreign reserves. In principle, there’s no
limit to how high these can go, but at some point a thing can
get so big that that in itself becomes a risk.”

While nations such as Singapore and Hong Kong already hold
reserves larger than their economies, printing Danish kroner to
buy foreign currency can lead to inflation in the longer term,
said Ian Stannard, head of European foreign-exchange strategy at
Morgan Stanley in London.

“With all these measures, there are consequences, economic
and political consequences,” Stannard said in an interview.
“That is ultimately what will determine the sustainability of
these policies.”

Experiment

Denmark’s experiment with negative rates may be most
relevant for the Swiss National Bank, whose battle to defend the
franc’s cap to the euro resembles Bernstein’s plight. Yet
Draghi, who also faces decisions on the ECB’s role in reducing
Italian and Spanish borrowing costs, can still get a sense of
how banks will react to negative rates from watching the Danes.

There’s a “great risk with this policy,” Mortimer-Lee at
BNP Paribas said. “Basically, you’re taxing bank intermediation
and at some stage you’re going to discourage bank intermediation
and you impede the credit policy.”

He warns that by making banking more expensive, the
industry’s ability to provide credit to the economy is
diminished.

“There are costs associated with banking,” Mortimer-Lee
said. “If you go too far and people start dis-intermediating,
the position of the banking sector would be made more difficult,
not easier, and that’s not where you want to go. You don’t want
to make credit creation more difficult.”

Capital Controls

Bernstein says that there’s no limit on how low the deposit
rate can be cut. He’s ruled out capital controls to defend the
krone’s peg to the euro, preferring instead to drag conventional
tools deeper into what he last month described as “uncharted
territory.”

Foreign reserves reached an unprecedented 511.6 billion
kroner ($84.6 billion) in June, versus an average of less than
200 billion kroner in 2000 to 2006. Denmark’s central bank
defends a 2.25 percent krone band against the euro, though in
practice it only tolerates moves well within that range.

The krone traded at 7.4429 to the euro as of 11:48 a.m. in
Copenhagen. That compares with a close of 7.4414 on July 5, the
day Nationalbanken cut rates.

The bank, which doesn’t hold scheduled policy meetings,
adjusts interest rates in tandem with the ECB to steer the
exchange rate through the rate differential. Currency market
interventions are an additional tool.

Capital Influx

Denmark has fought off a currency influx driven by investor
dismay over the euro zone’s failure to stem its crisis. Even
negative yields have failed to keep capital out as the prospect
of a euro-zone breakup underpins demand for kroner.

The yield on Denmark’s benchmark 10-year note traded 21
basis points lower than similar-maturity German bunds today. The
Nordic country’s 3 percent note due November 2021 rose four
basis points to 1.12 percent. The yield on its two-year note was
at minus 0.281 percent.

Denmark’s fiscal restraint and current account surplus have
also attracted investors alarmed at swelling debt burdens inside
the single currency bloc. The government of Prime Minister Helle
Thorning-Schmidt will post debt of about 40 percent of gross
domestic product this year and next, less than half the euro-zone average, the European Commission said in May.

Demand for the krone is unlikely to abate any time soon,
said Kasper Ullegaard, head of fixed income at Sampension AS.

Getting Burnt

“By this stage in the crisis, investors are used to
getting burnt if they don’t buy the safest paper, so that will
continue to attract them to Denmark,” he said.

According to Stannard at Morgan Stanley, “the pool of safe
havens in Europe is shrinking. While we see the pressure within
the euro zone continue to build, the safe havens will still gain
support,” he said.

The implied probability of a country leaving the monetary
union is 59 percent for next year, and 66 percent by the end of
2014, based on bets at Intrade.com. Citigroup Inc. said last
month there’s now a 90 percent chance that Greece will leave the
euro in the next 12 to 18 months, spelling prolonged economic
weakness and spillover for the currency bloc.

Though the Danish central bank “hasn’t yet run out of
tools, they will if this drags out,” Henrik Drusebjerg,
Copenhagen-based senior strategist at Nordea Bank AB, said in an
interview. “At some point, they will.”